Keep a close eye on credit quality, financials of NBFCs before investing

With non-bank financial companies (NBFCs) finding it difficult to raise funds from banks, the total issuance of non-convertible debentures (NCDs) from them is expected to cross the previous high this financial year, according to ICRA Ratings. In 2013-14, they had raised a record Rs 423.83 billion. With many of the recent issuances offering returns of above 9 per cent, investors are likely to be attracted to them. However, they should do proper due diligence before investing in these instruments.

After returns, the next thing that investors should check is the issuer's credit quality. "I would not invest in a company with credit rating below AAA. But if you wish to take some risk in pursuit of higher returns, you may go up to AA," says Deepesh Raghaw, founder, PersonalFinancePlan.in, a Sebi-registered investment advisor (RIA). The reason he cites for sticking to the highest-grade papers is that in India credit ratings can fall by several notches at one go.

He adds that a number of mutual fund (MF) houses also invest in NCDs, so one alternative way to take exposure to them is by investing in credit risk funds. These funds invest in papers below AA rating as well, but the risks they take are backed by a lot of research. Raghaw also recommends investing in NCDs of established housing finance companies (HFCs). "Since the default rates on home loans tend to be lower, established HFCs are unlikely to default on their NCDs," he says. He also suggests sticking to NCDs of established companies for whom the reputational risk of a default would be high.

At the time of investing, and even after, keep a close eye on the company's financials, especially its level of leverage.

"A company may promise you a 9 per cent plus return today, but if its financials deteriorate after a couple of years, you may not even get your principal back," says Mumbai-based financial planner Arnav Pandya. He adds that it is not prudent to lock yourself into an NCD for more than three-five years. "A few years later, if the company's financials take a knock, you could find yourself in trouble," he says.

The rate of return promised to you should be the compounded rate. "Many companies do fraudulent math when promising you a higher rate of return," says Raghaw. Suppose that you have invested Rs 100,000 and you get Rs 153,862 after five years. The compounded rate of return is 9 per cent. But the company may advertise that it is paying a return of 10.77 per cent (Rs 53,862 is the simple interest. This is divided by five, the number of years to arrive at an annual return of 10.77 per cent). Don't fall for such tricks.

Monthly, quarterly, six-monthly and yearly payout options are available. "If you take your payouts at longer intervals, your rate of return will be higher because of the compounding effect," says Pandya.

Do not to load your debt portfolio too much with NCDs. "These companies offer a high rate of return because they are unable to borrow from other sources at a lower rate, owing to the credit risk they carry. Hence, they should not constitute more than 15-20 per cent of your debt portfolio," says Pandya.

Finally, consider the alternatives available. Bank fixed deposit rates are rising. The three-year fixed deposit rate from SBI today stands at 6.70 per cent, but in the case of some banks like DCB it goes as high as 7.75 per cent. Moreover, the interest income you get from an NCD will be taxable at your marginal tax rate. "A person who doesn't need a regular income may be better off investing in a debt fund where he will become eligible for indexation benefit after three years," says Raghaw. The GoI Saving Bond which offers a return of 7.75 per cent is another option. Senior citizens should give priority to the Senior Citizens Savings Scheme, which offers a return of 8.3 per cent and also gives Section 80C tax benefit. Another option for them is the Pradhan Mantri Vaya Vandana Yojana (8-8.3 per cent return). These are government schemes with zero default risk.